Are bonds your safety belt? Buckle up.

Jean Paul Lagarde, BridgeTower Media Newswires

The balanced stock/bond portfolio is an artifact of old Wall Street that practitioners of all sorts, from advisers to brokers, flock to for risk mitigation. These portfolios have morphed over the years to include additional asset classes; however, the goal always remains the same — negatively correlated returns.

During times of market turbulence when equities are falling, these negatively correlated assets such as bonds might move in the opposite direction, acting as a shock absorber for your portfolio. Although this is a logical goal, the unfortunate truth is that the current investment landscape is significantly different than previous cycles and may result in the perceived safe harbor of bonds being merely a desert mirage, which could leave investors with larger than expected losses.

If we focus on bonds specifically, they pay a fixed “coupon” based on the instrument’s face value, and generally lose value during times of rising interest rates and gain value when rates move lower. The sensitivity of bonds to changes in interest rates increases as the effective maturity of the bond, measured in duration, rises. A bond with a duration of five would rise or fall approximately 5 percent with a 1 percent change in rates, while a bond with a duration of 15 would move roughly 15 percent.

Until just recently, bonds have enjoyed an unprecedented multi-decade tailwind pushing them along as rates. Ten-year treasuries for example, have fallen from 15.8 percent in September of 1981 to 1.46 percent in mid-2016. During this period, bonds not only returned their coupon or interest payment but also increased in value as rates continued to drop. This ultimately enhanced returns of the balanced stock/bond portfolio to unsustainable levels because rates can only drop so far before they hit zero, which would end this additional source of return for bonds.

An encore performance of the bond market is an extremely challenging prospect, due in part to the Fed’s current limitations in lowering rates. Just before the financial crisis, 10-year yields reached a high of 5.3 percent and fell to 2.1 percent by early 2009 and 1.46 percent by mid-2016, compared to 2.92 percent today. Shorter rates, such as 2-year yields, which the Fed has more control over through monetary policy, fell from a high of 5.1 percent to a low of 0.6 percent in December 2008, compared to the current level of 2.25 percent.

In the event of a crisis, the Fed can lower rates again. However, they will not have the positive impact on bonds that they had following the financial crisis unless the Fed decides to sink rates into negative territory. That said, even though the Fed’s actions on shorter-dated rates, cutting the Fed funds rate to zero, and longer-dated rates, purchasing over $4 trillion of government securities in the open market, balanced portfolios still suffered significant losses during the crisis. Select indexes demonstrate that a 60 percent stock and 40 percent bond portfolio declined between 22 and 25 percent from peak to trough.

Lower nominal and real rates also propelled equities. This is due in part to falling rates that decreased the discount rate of future corporate profits, increasing their present value and stock price to earnings multiples which sent stocks higher. During this period, the market as a whole was climbing higher and returns were relatively “easy.” They were so easy that many deemed active asset management to be unnecessary and too costly relative to cheap passive index products that were outperforming. Following this logic, various endowments and institutions reduced allocations to market-neutral long-short strategies that generally fair better during periods of market stress. The net result was an unprecedented period where stocks and bonds moved upward together rather than moving in opposite directions as intended for safety purposes.

Another challenge for bonds is that the longstanding tailwind of falling rates has now turned into a challenging headwind. Ten-year yields have risen from 1.46 percent in mid-2016 to 2.92 percent currently. Rates are expected to climb as the Fed signals that they will hike the Fed funds rate three times in 2018. The market is finally starting to believe them, evidenced in the movements of Fed funds futures. Driving the Fed’s confidence and the market’s belief therein are several factors. First, the economy has strengthened for six consecutive quarters on a year-over-year GDP basis. Second, labor market conditions continue to tighten. And finally, wage growth, widely regarded by the Fed as the critical missing link to sustainable inflation, has emerged. Given that the economy is roughly 70 percent consumer driven, inflation looks more believable now than ever.

Measures of inflation have been climbing for some time. The headline Consumer Price Index (CPI) that was negative for the first half of 2015 has increased to 2.1 percent as of January, while the Personal Consumption Expenditures Index (PCE) has risen from 0.2 percent to 1.7 percent over the same period. The market is fearful inflation could accelerate due to a trifecta of a tax cut that is fueling consumer and business confidence, a ballooning federal deficit exacerbated by the tax cut and a fiscal stimulus program normally reserved for recessions or depressions. The Nonpartisan Committee for a Responsible Budget expects the tax cut to reduce federal revenue by $1.5 trillion over a decade and balloon the budget deficit to $1.9 trillion by 2019.

The icing on the inflation cake is the fact that the U.S. dollar is weakening in relation to other currencies. This causes the price of dollar-denominated commodities and imported goods to rise. Thus, through a weakening dollar, we have been “importing” inflation to U.S. shores.

Previously, we have questioned the sustainability of ever increasing interest rates, inflation expectations and investor bullishness. Since that time, we have experienced some significant market turbulence. Although there could be a temporary relief for bonds in that inflation fears may be overstated that could limit further rate increases, we believe that the balanced stock/bond portfolio has run its course – and it has been a good run.

Today, however, the environment is completely different and the benefits of holding bonds as a portfolio protection mechanism are simply not worth it, considering the risks. The protection which seems to function when you need it the least, will more than likely vanish when you need it the most.

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Jean Paul Lagarde is portfolio manager and partner at Faubourg Private Wealth.